What is Uncle Sam doing with your tax money?

May 14, 2014 — Sam H. Fawaz

Now that your tax money is in the hands of Uncle Sam, what will he do with it?  How will the government allocate your contribution to the overall budget?
 
Your Social Security payments are easy; they go to pay Social Security benefits to current retirees, and for now (the future is another matter), they fully fund that obligation. Some of that money also goes to cover a portion of Medicare’s expenses; the remainder is covered by general federal revenue.
 
Your income taxes are divided among several broad budgetary categories.  A surprisingly large chunk is spent on the military (27%) and military-related veteran’s benefits (5.1%).  Another 22.7% goes to various forms of healthcare for U.S. residents, including the rest of the Medicare bill plus Medicaid.  13.9% of your tax money goes to pay interest on Uncle Sam’s debt–paid out to Treasury bill and bond holders every six months.  Unemployment benefits take up another 9.8%.
 
In the “Everything Else” category on the government spending pie chart, a surprisingly low 4.5% is spent on running the government, including various agencies such as the FBI and immigration services.  A total of 4% goes to housing programs, community development and block grants, while education gets a 2% slice of the pie–for programs like Head Start, and also the Pell Grants for college students.  Less than 2% is spent on scientific research, international affairs, transportation and energy.
 
If you’d like to get a receipt from the government for your taxes paid, which itemizes how that money is spent, well, good luck petitioning the IRS.  But you can get a fairly accurate receipt from the National Priorities Project here: http://nationalpriorities.org/interactive-data/taxday/. Just type in this year’s tax payment from your 1040, find your state, click a button and you’ll see what you paid for in terms of government services, interest and overhead.  Depending on how you feel about our government spending priorities, it may make your tax experience more or less painful.

If you have any questions about how to plan to pay less in taxes through tax and financial planning, please don’t hesitate to contact or visit us at www.ydfs.com.
 
 
Sources:
 
http://money.cnn.com/2014/04/11/pf/taxes/how-federal-income-taxes-are-spent/index.html
 
http://nationalpriorities.org/interactive-data/taxday/

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Employers Ramping Up Retirement Plan Features

April 29, 2014 — Sam H. Fawaz

Employers are enhancing their retirement plans and increasing access to professional investment advice in an attempt to bolster employee retirement readiness.

A new study by Aon Hewitt, which polled more than 400 plan sponsors serving 10 million plan participants, revealed a number of initiatives being taken to strengthen employee ability to achieve greater financial security in retirement. Key actions include the following:

  • Boosting employer matching funds: The percentage of employers offering dollar-for-dollar matches on the first 6% of employee contributions, has nearly doubled in the past two years, from 10% in 2011 to 19% today. And virtually all employers now offer some level of matching contributions.
  • Offering immediate eligibility: Three out of four employers now allow employees to begin participating in a workplace retirement plan as of their hire date — a dramatic increase over the 45% of employers that offered immediate plan eligibility in 2001. In addition, more than half of employers also offer “day one” access to employer matching contributions.
  • Providing access to Roth-style plans: Giving plan participants the option of choosing between a standard defined contribution plan and a Roth-style plan has become a priority for more employers in the past several years. Now 50% of employers allow Roth contributions (up 11% since 2008), and of those who offer the Roth option, 27% currently allow in-plan Roth conversions. Another 16% will offer this feature within the year.
  • Offering access to a range of advisory services: One of the fastest-growing benefit trends is the availability of various types of professional guidance, which is now offered by three out of four plan sponsors. One-on-one financial counseling tops the list (with 59% of plans offering), followed by online guidance (55% of plans), and managed accounts (52% — a significant jump from just two years ago when only 29% of plans offered this feature). Target-date funds — another form of investment guidance — are well into the acceptance curve, with 86% of plan sponsors offering them.

If you have any questions about your employer retirement/benefit plans or any other fee-only fiduciary financial planning matters, please don’t hesitate to contact us or visit http://www.ydfs.com.

Source:  Aon Hewitt news release, October 30, 2013.

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Should You Consider a Health Savings Account?

April 28, 2014 — Sam H. Fawaz

As health care costs continue to rise, consumers must find ways to ensure that they have the funds to pay for medical expenses not covered through their insurance. One way to save specifically for health care costs is to fund a health savings account, or HSA.

HSAs are tax-advantaged savings accounts set up in conjunction with high-deductible health insurance policies. Enrollees or their employers make tax-free (pre-tax) contributions to an HSA and typically use the funds to pay for qualified medical care until they reach their policy’s deductible. The contribution made to the health savings plan is made in addition to your health insurance premium.

HSAs are not for everyone, and it is important to understand how they work before considering them to help fund health care costs.

Understanding HSAs

You are eligible for an HSA if you meet all four of the following qualifying criteria:

  1. You are enrolled in a qualified high-deductible health insurance plan (known as an “HDHP”).
  2. You are not covered by any additional health plan(s).
  3. You are not eligible for Medicare benefits.
  4. You are not a dependent of another person for tax purposes.

HSAs are generally available through insurance companies that offer HDHPs. Many employer-sponsored health care plans also offer HSA options. Although most major insurance companies and large employers now offer an HSA option under their health plan, it’s important to remember that most health insurance policies are not considered HSA-qualified HDHPs, so you should check with your insurance company or employer to see how an HSA plan might differ from your current plan.

There are maximum contribution limits that are adjusted annually. Contributions are made on a before-tax basis, meaning they reduce your taxable income. Note that unlike IRAs and certain other tax-deferred investment vehicles, no income limits apply to HSAs.

HSAs offer investment options that differ from plan to plan, depending upon the provider, and allow users to carry account balances over from year to year. Earnings on HSAs are not subject to income taxes.

Any medical, dental, or ordinary health care expense that would qualify as a tax-deductible item under IRS rules can be covered by an HSA. A doctor’s bill, dental procedure, and most prescriptions are examples of covered items. See IRS Publication 502 for a definitive guide of covered costs. If funds are withdrawn for any purposes other than qualifying health care expenses, you will be required to pay ordinary income taxes on amounts withdrawn plus a 10% additional federal tax.

Here are some pros and cons of this product.

Pros

  • HSAs offer a significant annual tax deduction, making them particularly appealing to individuals in higher tax brackets.
  • Withdrawals for qualifying health care costs (including long-term care insurance) are tax free.
  • Investment income in HSAs also accumulates tax free.

Cons

  • Since HSAs must be tied to HDHPs, their ultimate savings must be weighed against how such plans stack up against more traditional plans, which may offer significantly better coverage.
  • HSAs may not offer the flexibility and portability that today’s mobile American family requires, especially given that health plan offerings differ significantly from employer to employer, and many smaller institutions have yet to offer an HSA option.
  • For more information on HSAs, see the U.S. Treasury’s Health Savings Account resource page.

If you have any questions about Health Savings Accounts or any other financial planning matters, please don’t hesitate to contact us or visit http://www.ydfs.com

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Taking Distributions from 529 College Savings Plans

April 26, 2014 — Sam H. Fawaz

Parents looking to take advantage of the many benefits of saving for college with a 529 plan will want to know the full details of which educational expenses qualify for tax-free distribution status — and which do not.1 In Publication 970, the IRS gives detailed guidance on qualified expenses. Here are a few important points:

What’s Covered

 Tuition and fees are covered in full.

  • Room and board, if the student is enrolled at least half time. But such expense must be not more than the greater of (1) the allowance for room and board, as determined by the school, that was included in the cost of attendance; or (2) the actual amount charged if the student is residing in housing owned or operated by the school.
  • Food. If you spend a certain amount for a meal plan, that entire amount can be deducted, even if used for coffee or ice cream and not a full meal. Weekend meals can also be included if the dining halls are not open.
  • Books and supplies. Any fees associated with purchasing school textbooks are considered qualified, as are required equipment or supplies such as notebooks and writing tools.
  • Computers/laptops, but only if required by the school. If required, Internet fees and PDAs or “smartphones” may also qualify. The Savings Enhancement for Education in College Act (H.R. 529) that is currently being considered by Congress would expand this definition to apply to all computer technology used by the student.
  • Special needs services required by special-needs students that are incurred in connection with enrollment or attendance at school.

 What’s Not Covered

 Student loans. Interest on or repayment of student loans is not considered a qualified expense by the IRS.

  • Insurance, sports or club activity fees, and many other types of fees that may be charged to students but are not required as a condition of enrollment.
  • Transportation to and from school.
  • Concert tickets or other entertainment costs, unless attendance is requisite to a course or curriculum.
  • Note that expenses must apply to a qualified college, university, or vocational school for post-secondary educational expenses. Also keep in mind that taxes and a possible 10% additional federal tax will apply to all distributions that are not considered qualified educational expenses by the IRS, so be sure to check first.

If you have any questions about saving and investing for college, please don’t hesitate to contact us or visit http://www.ydfs.com

1By investing in a 529 plan outside of the state in which you pay taxes, you may lose the tax benefits offered by that state’s plan. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary.

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Would You Pay Less Taxes in Another Country?

April 25, 2014 — Sam H. Fawaz

Tax day has passed in the U.S., along with the usual complaints about the complexity and financial burden that federal and state taxes (and FICA) impose on our lives. But have you ever wondered how U.S. taxes compare with what citizens in other countries have to pay?

Recently, the accounting firm PricewaterhouseCoopers calculated the tax burden, for tax year 2013, for people living in 19 of the G20 nations (the 20th member is the European Union, which has a variety of tax regimes). The report looked first at people who are in the upper-income levels–a person with a salary equivalent of $400,000, with a home mortgage of $1.2 million. After all income tax rates and Social Security (or equivalent) contributions have been taken out, what percentage of his/her income would this person have left over?

The people we should have the most sympathy for on our annual tax day live in Italy, where this person would get to keep $202,360 of that $400,000 income–or 50.59%. A comparable person living in India would keep 54.9%, while someone living in the United Kingdom would keep 57.28%.

Here’s the full list. Notice that the U.S. is about in the middle of the pack:

19. Italy – 50.59%
18. India – 54.90%
17. United Kingdom – 57.28%
16. France – 58.10%
15. Canada – 58.13%
14. Japan – 58.68%
13. Australia – 59.30%
12. United States – 60.45%
11. Germany – 60.61%
10. South Africa – 61.78%
9. China – 62.05%
8. Argentina – 64.02%
7. Turkey – 64.64%
6. South Korea – 65.75%
5. Indonesia – 69.78%
4. Mexico – 70.60%
3. Brazil – 73.32%
2. Russia – 87%
1. Saudi Arabia – 96.86%

Before you conclude that the U.S. is below average on this list, you should know that PricewaterhouseCoopers applied New York state (13.3%) and New York city (maximum 3.9%) taxes on the American calculation. If it had used Texas or Florida state tax rates instead, the U.S. would easily have ranked somewhere in the top ten.

And this list is somewhat skewed because so many European countries are left off, because they are lumped into the EU. It also doesn’t include Canada, which imposes a 29% top federal tax rate on its citizens, and then tacks on a maximum 25.75% rate at the province level.

PricewaterhouseCoopers did include many of the EU countries when it calculated the tax burdens on people with average incomes, and here the list looks somewhat different. The accounting firm assumed that a hypothetical married couple, with two children, earned the average income in each nation, and then calculated the overall tax rate the family would have to pay.

Denmark – 34.8%
Austria – 31.9%
Belgium – 31.8%
Finland – 29.4%
Netherlands – 28.7%
Greece – 26.7%
United Kingdom – 24.9%
Germany – 21.3%
United States – 10.4%
South Korea – 10.2%
Slovak Republic – 10%
Mexico – 9.5%
Chile – 7%
Czech Republic – 5.6%
(China, Russia, South Korea, Indonesia and Brazil would assess 0% taxes on this hypothetical family)

Does this mean that the U.S. tax system is fair? Or equitable? It depends on your perspective. Tax rates in the U.S. have been as high as 94% on all income over $200,000 (1944-45), and as low as 28% (1988-1990), with the bulk of years coming in between 40% and 70%. Meanwhile, some countries assess more taxes from corporations than from their citizens, while some have it the other way around. And some nations are evolving. At the beginning of World War II, individuals and families paid 38% of the total federal tax burden, and corporations picked up the other 62%. Today, thanks to aggressive lobbying, corporations have turned that around and then some. Individuals and families pay 82% of today’s total federal income tax haul, and corporations pay 18%.

We should also remember that high taxes don’t necessarily correlate with economic misery or poverty. Consistently, Belgium, which had the highest tax burden on average wage-earners (and imposes a top 50% rate on upper-income citizens) also consistently scores as one of the happiest countries in the world.

Sources:

http://www.bbc.com/news/magazine-26327114

http://billmoyers.com/2013/10/03/the-us-has-low-taxes-so-why-do-people-feel-ripped-off/

Click to access nyc_tax_rate_schedule.pdf

http://www.ntu.org/tax-basics/history-of-federal-individual-1.html

 

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20 Things to Know about the Russian Incursion into Ukraine

March 15, 2014 — Sam H. Fawaz

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Our hearts and prayers go out to the people of Ukraine, as they undergo both an internal political crisis and what appears to be military intervention from Russia.  For people of a certain age, the current events, with tanks rolling across the Russian border into a neighboring nation that wants to exercise its freedom, it feels a bit like the Cold War days all over again.

Whenever we see troop movements and fires raging in the streets of a capitol city the size of Chicago, our instinct is to assume the worst and move our money to the sidelines.  But is this really the best strategy?  Some commentators see any market downturn as a buying opportunity, since stocks are going on sale simply because of unfounded fear of economic aftershocks.

Here are some facts that you might not know about what has, hitherto, been a relatively quiet new member of the world economic community.

1) The word “Ukraine” means “borderland” in proto-Slavic.  It appears to have acquired this name simultaneously from Poland, Austria and Russia, referring to the territory that sits across the border of so many European nations and Russia.  In fact, the Polish referred to their troops stationed in this area as Ukranians–that is, borderlanders.  Since the country became independent from the Soviet Union, it is no longer referred to internationally as “The Ukraine.”

2) Ukraine’s currency is the hryvnia, adopted in 1996 after the country suffered the greatest one-year bout of hyperinflation in global economic history.  (Zimbabwe has since broken the record.)  Today, one dollar will buy 9.6 hryvnias.  A euro will buy 13.3 of them.

3) After Russia, Ukraine has the largest military presence in Europe.  Ukrainian troops have been deployed as part of international peacekeeping missions in Somalia, Kosovo, Lebanon and Sierra Leone, and has engaged in multinational military exercises with U.S. military forces.  NATO has accepted Ukraine as a member pending a national referendum on the matter–which will obviously be delayed until the conflict with Russia has played itself out.

4) Ukraine has one of the world’s most active space programs.  The National Space Agency of Ukraine has launched six self-made satellites and a total of 101 launch vehicles.  The country also manufactures the An-225 aircraft, the largest aircraft ever built.

5) Due to low birth rates, Ukraine’s population is declining at the sixth fastest rate in the world, behind the Cook Islands, the Federated States of Micronesia, the Northern Mariana Islands, Niue (an island nation in the South Pacific) and the Eastern European nation of Moldavia, which borders Ukraine.

6) Nevertheless, Ukraine’s largest city, Kiev, has a higher population (2.8 million) than Chicago, America’s third-largest city.  The population of Kharkiv, Ukraine’s second-largest city (1.4 million), is greater than San Antonio, San Diego and Dallas, America’s seventh, eighth and ninth most populous cities.

7) According to the World Bank, Ukraine’s economy is the 51st largest in the world, ranking just behind Peru and the Czech Republic,a nd just ahead of Romania and New Zealand.  But its $7,295 (US) per-capita income (a rough measure of a nation’s wealth) ranks 106th in the world, behind Namibia and El Salvador and ahead of Algeria, Micronesia and Iraq.

8) Ukraine co-hosted the Euro 2012 football (soccer) tournament (with Poland), which is one of the major sporting events in Europe.

9) Even though the Chernobyl nuclear disaster occurred in Kiev, Ukraine operates the largest nuclear power plant in Europe.

10) Despite comments that Ukraine is divided between ethnic Ukrainians and Russia, 77.8% of the population is ethnic Ukraine, and only 17.3% is Russian.

11) Ukraine is known as the “breadbasket of Europe” for good reason.  The country is the world’s fourth largest producer of barley, 5th largest producer of rye, 11th largest producer of wheat, the 6th largest producer of oats and the 9th largest producer of soybeans.

12) Russia sells approximately 80% of its oil and gas exports to the European Union through pipelines that pass directly through Ukraine.  The European Union receives 25% of its oil and gas from Russian sources through these conduits.

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13) Ukraine also happens to be Russia’s second-largest customer of petro-fuels.

14) Russia is drilling for oil in the shallow waters of the Black Sea near the Crimean Peninsula, which shows promise of having significant reserves.

15) Among others drilling in the same area: Chevron and Shell Oil.  If they begin production under the Ukrainian flag, it would significantly undercut Russia’s oil and gas market share and prices, simultaneously boosting Ukraine’s economy.

16)  When the Russians (as the Soviet Union) invaded Afghanistan in 1979, the U.S. and many Western nations boycotted the 1980 Olympic games, which were hosted in Russia.  Is it interesting that Russia decided to move forces into Ukraine immediately AFTER the Sochi Olympics were finished?

17) Among the most likely responses to the Russian/Ukrainian crisis is the cancellation of the upcoming G8 summit in Sochi.  Another possible response might remove Russia from the G8 club.  This would embarrass Russian strongman Vladimir Putin at home and isolate him (and Russia’s economy) abroad.

19)  Russia’s economy could be the big loser in the aftermath of the Ukrainian crisis.  Share prices for companies based in Russia declined by 10 percent the day after mysterious soldiers took over the Crimean peninsula, also triggering an outflow of domestic currency that Russia desperately needs to invest in modernizing an economy largely (today) based on selling abroad what is pumped or mined out of the ground.

20) The threat of disruption of trade between Western nations and Russia (either due to sanctions or reluctance to deal with a country that doesn’t seem to be focused on following international law) cost the Russian economy $60 billion in a matter of days–more than the total cost to stage the Sochi Olympics.

21) (bonus) Let’s assume that we are not headed toward a world war.  Several commentators have unhelpfully pointed out that the Crimea became the flashpoint for World War I, but the world is somewhat different today.  There could be some impact from higher energy prices in Europe if the Ukraine pipelines are disrupted temporarily, but Russia needs to sell its oil and gas as much as Europe needs to buy it.  Unless someone is heavily invested in Russian stocks, the crisis will likely be seen as a portfolio non-event.

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Sources:

http://www.cnbc.com/id/101458530

http://redmoneyupdate.com/tag/ukranian-crisis-and-how-it-may-impact-investments/

http://www.fool.com/investing/general/2013/12/10/growing-uncertaintly-in-the-ukraine-could-impact-l.aspx

http://en.wikipedia.org/wiki/List_of_largest_producing_countries_of_agricultural_commodities

http://en.wikipedia.org/wiki/Ukraine

http://www.reuters.com/article/2014/03/03/us-urkaine-crisis-russia-economy-analysi-idUSBREA221D020140303

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Is myRA Your Next Retirement Plan?

February 16, 2014 — Sam H. Fawaz

Chances are, you’ve heard about the new myRA retirement savings program that was proposed by President Obama during his State of the Union speech.  But what is it, and how does it relate to the array of other retirement savings options you already have–including, of course, traditional and Roth IRAs, 401(k) or 403(b) plans?  Is this something you need to be looking at in addition to, or instead of one of these other options?
 
The new account, which is scheduled to be introduced later this year, will be offered to workers who currently don’t have access to any kind of retirement program through their employers.  Remarkably, this underserved population is actually about half of all workers, mostly those who work for small companies which have trouble affording the cost of creating and administering a 401(k) plan.  The idea is that a myRA would be so easy to install and implement (employers don’t have to administer the invested assets), and cost so little (virtually nothing), that all of these smaller companies would immediately give their employees this savings option.
 
Only some of the employees would be eligible, however.  Married couples earning more than $191,000, or singles earning more than $129,000, would be excluded from making myRA contributions.  And there is currently no law which says that employers would be required to offer these plans.
 
So the first thing to understand is that people who already have a retirement plan at work, or who earn more than the thresholds, shouldn’t give the myRA option a second thought.
 
Nor, frankly, would those people want to shift over to this option.  Why?  myRA functions much like a Roth IRA, which means that contributions are taxed before they go into the account just like the rest of a person’s salary, but the money will come out tax-free.
 
Anybody can make annual contributions to a Roth IRA; the 2014 maximum is $5,500 for persons under age 50; $6,500 if you’re 50 or older–and these are the same limits that will be imposed on the myRA.  BUT–and this is a big issue–the myRA is not really an investment account.  Any funds that are contributed to a myRA account earns interest from the federal government at the same rate that federal employees earn through the Thrift Savings Plan Government Securities Investment Fund–which is another way of saying that the money will be invested in government bonds.
 
Why does that matter?  Retirement accounts that invested solely in the stock market earned close to 30% from their stock investments last year.  The government bond investments that would have gone into a myRA earned 1.89% last year–which is below the inflation rate.  In real dollars, that was a losing investment.
 
Another big issue is the employer match.  Many workers who have a traditional 401(k) account get some of their contributions matched by their company, which effectively boosts their earnings.  myRA accounts will get no such match.
 
The Obama Administration clearly understands the difference between saving in a government bond account and actual investing.  Accordingly, there is a provision that whenever a myRA account reaches $15,000, it has to be rolled into a Roth IRA, where the money can be deployed in stocks, bonds or anywhere else the account holder chooses.  The program seems to be designed to encourage younger workers to start saving much earlier than they currently do.  Statistics show that the median retirement account for American workers age 25-32 is just $12,000, and 37% have less than $5,000. 
 
Will they be motivated to save when myRAs roll out at the end of the year?  Some commentators have noted that the money can be taken out of the account, for any reason, at any time, with no tax consequences.  That’s not a great formula for long-term savings.  But it does make the myRA account a convenient way for a worker just starting out to build up a cash reserve which could serve as a cushion against job loss or unexpected expenses like car repairs.  If it is not needed, the account could eventually grow into a retirement nest egg.
 
If you have any questions about the myRA or any other investment, retirement or financial planning matter, please don’t hesitate to ask.  We are a fee-only financial planning firm that always puts your interests first.

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Using Options To Enhance Portfolio Returns

February 8, 2014 — Sam H. Fawaz

When people think or hear about using options in their investment portfolios, they tend to think of them as risky instruments that lose their entire value, or worse, cause them to lose multiples of their value. But when used correctly, options can be a powerful tool to help enhance portfolio income, reduce overall portfolio risk, and make risk-defined bets on a stock, sector or fund.

What’s an Option

An option is a financial instrument, tied to or based on an individual stock or exchange traded fund, which gives the purchaser the right, but not the obligation, to buy or sell an underlying stock or fund. Options are unique in that they have a defined price to buy or sell the shares and a limited time to do so.  If you don’t “exercise” your right to buy or sell the shares within the time limit, whatever you pay for the option expires and is lost.

Options are sold as “contracts” for 100 shares each.  Remember, with options, you’re buying the right to buy or sell shares, not the shares themselves

There are two basic kinds of options: calls and puts. Let’s talk about each.

Calls and Puts

Think of calls as options to buy a stock or fund at a certain price. I liken a call to an option to buy a home at a certain price for a defined amount of time.

Let’s say that you’re interested in buying a home for $250,000 but aren’t sure that you can get the financing or whether the house is really worth the asking price. So you might offer the seller a sum of money to hold and sell you the house for $250,000 within 90 days. You might pay him a $2,500 “premium” for that option while you investigate financing or determine the true value of the home. During that time, the seller can’t offer to sell the home to anyone else.

If you can’t secure the financing, or you find out that the house is worth far less than $250,000, then you walk away having spent $2,500 for that right (but not the obligation) for 90 days to buy the home. If the true value of the home turns out to be $200,000, you just saved yourself $50,000 less the cost of the option (or $47,500).  If the value of the home instead turns out to be $300,000, then the seller is still obligated to sell you the house for $250,000. In that case, you would exercise your option and you just made an unrealized profit of $47,500 ($300,000 less $250,000 less the cost of the option or $2,500).

Think of puts as an option to sell a stock or fund at a certain price. In many ways, a put is akin to an insurance policy.

Let’s say that house that you just bought for $250,000 is insured for $250,000 and then burns down for a total loss. In that event, the insurance company would pay you for your loss as you “put” the (burned down) house to them. But in order to do that, you had to pay the insurance company an annual insurance premium of say $2,000. If nothing happens to the home, that premium paid is lost forever.

A Stock Example

Let’s turn the discussion to call options on stocks.

Say that you own 100 shares of Apple common stock currently trading for $500, which you bought for $400 per share and you want to generate additional income on those shares (besides the corporate dividend). To do so, you can sell a call option giving someone the right to “call away” your shares for a per share price of $550 within 45 days. For that sale, someone might pay you $1,000 (you don’t ever know who that someone is, but there’s always a willing buyer at the option exchanges for the right price). Note that there are many prices (called strike prices) that you can choose from to decide where you want to part with your Apple shares.

In this example, if Apple shares move down or never exceed $550 per share by the time the option expires, the buyer of that option will walk away without buying the shares and will be out $1,000, but you’ll be $1,000 richer. In that case, you keep your Apple shares and then repeat the process at a new appropriate sales price. Remember, if the buyer of the option can buy shares on the open market for less than $550, she has no reason to exercise that option.

If, on the other hand, Apple shares are at $575 by expiration, you’ll have to part with your shares for a price of $550 (plus the $1,000 that you pocketed for selling the option). The buyer of the option the exercises her option and then owns the shares and any appreciation over $550. You just made $150 per share profit plus the $1,000 option premium. You can then choose to buy new shares of Apple and repeat the process at a higher option price.  Note that the option buyer can call away the shares any time before they expire, but won’t do so unless the price of the shares is higher than $550.

Of course, with any option, you’re free to be the buyer of the calls to speculate on the price of any stock or fund. In the Apple example above, you could have been the buyer of the call option instead of being the seller and thereby speculate on the price of Apple appreciating.

So what about put options on a stock?

Lets continue the Apple example above. At $500 market value per share, you currently have $100 of unrealized profit per share. Now suppose you’ve become worried about a short-term decline in the overall market or in the price of Apple shares, but you don’t want to sell them yet.  Just in case, you might want a short-term insurance policy in the event that Apple shares tumble. In this case, you might buy a $500 put option for $1,000 to give you the right to “put” those shares to someone else for no less than $500 each.

So if Apple shares drop to $450, you’ll still get $500 for your shares when you exercise your put and the seller of the put will be out $4,000 ($500 minus $450 times 100 shares less $1,000 premium received). However, if the shares of Apple are trading for more than $500 by the expiration of the put option, then the put expires worthless and you’re out $1,000 and the seller pockets $1,000.

Safe Ways To Use Options

By now you may have realized that selling options is a nice way to make some extra income. When you consider that most options expire worthless, it is indeed better to be the “house” selling the options rather than the “bettor” buying the options.

The above examples are greatly simplified to help you with the understanding of options. We’ve left out all the mechanics and nuances of option trading to aid in understanding.

The reason that options get such a bad rap is because most people are buyers of options rather than sellers, and they usually buy far too many of them. Since each option contract is good for 100 shares, you shouldn’t buy or sell more contracts than you would buy or sell an equivalent number of shares of stock. Some people even sell calls on stocks that they don’t own (this is allowed), not realizing that stocks can sometimes go much higher than they can imagine. So if you sell an option “naked”, to a certain extent, you’re taking nearly unlimited risk.

In our client portfolios, we may generate income by selling calls against shares we own, so we only have the risk of the stock being called away. We may also hedge our portfolios with options to take advantage of short-term volatility. We may do so by trading puts, but do so in a risk defined way to minimize our premium outlay or maximize our premium generation. In other words, we don’t take unnecessary unlimited risk bets with options and use them only in the safest ways possible.

Hopefully this post helps you to better understand how we (and you could) use options in your own investment portfolios. Of course, if you want to dabble in options, I highly recommend that you get yourself a good book on options and study it carefully before trying them out. Option investing is where a little bit of knowledge is helpful, but can also be dangerous if you’re not sure what you’re doing.

If you’d like to know more about what we do to enhance and hedge investment portfolios, please don’t hesitate to contact us or just ask any questions.

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Market Correction?

January 27, 2014 — Sam H. Fawaz

Last Monday, the U.S. markets dropped roughly 1% of their value (as measured by the S&P 500 index), and Europe and Asia were down by similar amounts the following day. The market then fell 2.1% on Friday in a sickening lurch. Today the S&P 500 fell another 0.5%. This combination was enough to cause pundits and investors to ask whether we are now in the early stages of a bear market or, indeed, if the past almost-five years should be considered an interim market rally inside of a longer-term bear market.

The answer, of course, is that nobody knows–not the brainiac Fed economists, not the fund managers and certainly not the pundits. A Wall Street Journal article noted that most of the sellers on Friday were short-term investors who were involved in program trading, selling baskets of stocks to protect themselves from short-term losses. Roughly translated, that means that a bunch of professional traders panicked when they learned that Chinese economic growth is slowing down on top of worries that the Fed is buying bonds at a somewhat less furious rate ($75 billion a month vs. $85 billion) than it was last year.

What we DO know is that it is often a mistake to panic sell into market downturns, which happen more frequently than most of us realize. A lot of people might be surprised to know that in the Summer of 2011, the markets had pulled back by almost 20%–twice the traditional definition of a market correction–only to come roaring back and reward patient investors. There were corrections in the Spring of 2010 (16%) and the Spring of 2012 (10%), but almost nobody remembers these sizable bumps on the way to new market highs. Indeed, most of us look back fondly at the time since March of 2009 as one long largely-uninterrupted bull market.

Bigger picture, since 1945, the market has experienced 27 corrections of 10% or more, and 12 bear markets where U.S. equities lost at least 20% of their value. The average decline was 13.3% over the course of 71 trading days. Perhaps the only statistic that really matters is that after every one of these pullbacks, the markets returned to record new highs. The turnarounds were always an unexpected surprise to most investors.

We may get a full 10% correction or even a full bearish period out of these negative trading days, and then again we may not. But history suggests an important lesson: if we DO get a correction or a bear market, we may not remember it a few years later if the markets recover as they always have in the past. The people who lose money in the long term are not those who endure a painful market downturn, but those who panic and sell when the market turns down. The facts are that the market is overdue for a reasonable correction after the torrid and virtually uninterrupted run up we’ve had since late 2012.

Instead of panic selling into the market downturn, you may choose to lighten up your equity weighting or re-balance some of your equity weight into other asset classes. After a long winning run, it never hurts to take some profits off the table, trim back your winners and leave the proceeds in cash to invest when the downturn ends. There are various inverse funds and other options available to partially hedge your portfolio if the uncertainty keeps you up at night. After a few days of selling, there’s usually a rally around the corner to counterbalance the weight of the selling and that’s a more opportune time to lighten up. None of this is a recommendation–they’re just some ideas to consider.

For our clients, we have raised and maintained a healthy level of cash and have used hedging to reduce our overall portfolio risk. If the correction becomes prolonged, we’ll do more of the same and await the next opportunities to re-invest. No one says that you have to stay 100% invested at all times.

If you have any questions or would like to speak to us about your portfolio needs or any financial planning matters, we’re here to help. We are a fee-only financial planning firm that always puts your interests first.

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Expiring Tax Provisions: How You Probably WON’T Be Affected

November 28, 2013 — Sam H. Fawaz

Happy Thanksgiving! I hope that your families and you have an enjoyable holiday and (hopefully) extended weekend.

You may have read that the last day of 2013 is scheduled to be the last day for an estimated 57 different tax deductions–unless the U.S. Congress turns its attention away from the next potential government shutdown and extends some or all of them.  All of these deductions will be available to the 2013 tax return that you file by April 15.  But as it stands now, they won’t be available next year, creating another potential stealth tax increase in 2014.
 
How will this impact you?  Only a few of the 57 are relevant to you at all, unless you qualify for the American Samoa Economic Development Credit, the “special expensing” rules for film and television production, the mine rescue team training credit or special three-year depreciation for your race horses that happen to be two years or younger.
 
You probably do, however, claim deductions for state and local taxes, which expire at the end of the year, and people with kids and/or grandkids in college might miss the above-the-line deduction for tuition and related educational expenses.  Many Americans will be at least slightly affected by the loss of the deduction for mortgage insurance premiums, and some retired Americans over age 70 1/2 will be distressed to learn that they can no longer make tax-free distributions of up to $100,000 from an IRA account to their favorite charity.  School teachers will lose their classroom expense deductions of up to (a whopping) $250 for un-reimbursed expenses.
 
And thousands of homeowners whose homes are listing below what they paid for them should realize that, at the end of December, they will lose a provision that lets them exclude from their taxable income any reduction in their mortgage obligation (through debt modification or a short sale) up to a maximum of $2 million.
 
Other expiring tax breaks that may affect some people reading this:
 
-Enhanced tax breaks for people who donate property (or easements on their property) to the Nature Conservancy or a local land trust.
 
-Tax credits for the purchase of 2- or 3-wheeled electric vehicles and a separate credit of $7,500 for those who buy certain 4-wheeled electric vehicles like the Ford Focus Electric and the Nissan Leaf.
 
-A maximum $500 tax credit for making certain energy-efficiency improvements in your home (like adding insulation), plus other credits for constructing new energy-efficient homes and a credit for energy-efficient appliances.
 
The biggest expiring corporate tax break is the research and development tax credit.  At the end of the year, companies will also lose the additional first-year depreciation for 50% of the basis of qualified property.
 
In the past, Congress has allowed tax provisions to expire and then, retroactively, extended them for another year or two–and many tax observers believe this will almost certainly happen with the state/local tax deduction and corporate R&D tax credits, and quite possibly for the tuition tax credit as well. 

So when you read about the 57 expiring provisions, and you are not in the biodiesel fuel business (four expiring credits) or planning to claim the electricity production credit for building a renewable power plant, or actively mining coal on Indian lands, you shouldn’t get too worried.  Chances are you aren’t going to get hammered on next year’s taxes–and Congress may even get around to extending the provisions that you really care about, at the very last minute of course.

Whether you’re looking for year-end tax planning, financial planning or money management help, please get in touch with us for unbiased, fiduciary advice that always puts your interests first.

I welcome your feedback, questions and comments. Have a great long weekend!

Source: https://www.jct.gov/publications.html?func=startdown&id=4499

 

My thanks to Bob Veres, publisher of Inside Information, for his help with this post

 

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